SCSI 

DsSb 


UC-NRLF 


B    3    111    37t. 


CM 

in 

C\J 


DEPRECIATION 
IN  THEORY  AND  PRACTICE 


ONE  OP  A  lERIES  OF  LECTURES  IN  A  SYSTEMATIC  COURSE 


EARL  A.  SALIERS,  Ph.D. 

Instructor  in  Accounting  and  Investments 

Yale  University 

Author  of  Prmciples  of  Depredation 


ta  Salle  Extension  University 
•     Chicag^o 


DEPRECIATION 
IN  THEORY  AND  PRACTICE 


EARL  A.  SALIBRS,  Ph.D. 

Instructor  in  Accounting  and  Investments 

Yale  University 

Author  of  Principles  of  Depreciation 


La  Salle  Extension  University 


Chica  go 

1919 


(7-319) 


U  r  "^ 


Copyright,  1915 
LaSalle  Extension  Univeksitt 


• .  •   • 


•  •  •  •     • 


DEPRECIATION    IN    THEORY    AND    PRACTICE 

Introduction 

The  depreciation  problem  is  one  of  live  importance.  It 
has  recently  attracted  much  attention  on  the  part  of 
accountants  and  engineers  interested  in  the  solution  of 
problems  of  a  financial  character.  Although  the  litera- 
ture on  the  subject  is  constantly  growing  in  volume,  it 
is  often  difficult  for  the  student  to  secure  a  good  knowl- 
edge of  the  fundamentals  of  the  subject  because  of  the 
form  which  most  of  the  recent  discussions  have  taken. 

Almost  all  of  the  material  on  the  subject  is  in  the  form 
of  magazine  articles.  Usually  the  writer  of  such  an 
article  fails  to  cover  the  field  fully,  preferring  to  expand 
on  some  point  in  which  he  is  especially  interested. 

It  is  needless  to  say  that  this  lecture  does  not  cover 
in  detail  all  phases  of  the  matter.  On  the  contrary,  in  the 
attempt  to  cover  the  essential  features  of  the  problem  it 
has  been  necessary  to  omit  referring  to  many  things  of 
secondary  importance^  It  is  believed,  however,  that  this 
lecture  covers  the  most  important  features  of  the  prob- 
lem, and  if  an  interest  in  the  subject  and  a  fair  under- 
standing of  its  leading  features  is  acquired  by  the  student 
its  purpose  will  have  been  fulfilled. 

Depreciation 

By  depreciation  is  meant  the  losses  of  plant  value  aris- 
ing from  physical  or  functional  decay,  excepting  such 
losses  as  are  compensated  for  through  current  repairs. 

From  the  standpoint  of  the  cause  of  depreciation  it  is 
either  (a)  physical  or  (b)  functional. 

3 


4  EARL  A.  SALIERS 

Physical  depreciation  arises  from  wear  and  tear, 
weathering,  and  all  other  causes  which  diminish  the 
strength  or  usefulness  of  the  physical  parts  composing 
the  plant. 

Functional  depreciation  is  the  result  of  obsolescence  or 
inadequacy. 

Obsolescence  occurs  when  some  new  invention  or  dis- 
covery partially  diminishes  the  worth  of  a  machine  or 
other  part  of  the  plant. 

Inadequacy  arises  through  failure  of  the  plant  to  fulfil 
well  its  proper  function,  and  it  is  usually  the  result  of 
expanding  markets,  community  growth,  etc. 

In  addition  to  the  foregoing  classification  it  is  useful, 
for  certain  purposes,  to  further  classify  depreciation  into 
unit  and  composite  depreciation. 

Unit  depreciation  is  the  loss  in  value,  arising  from 
either  physical  or  functional  causes,  of  a  machine,  or 
group  of  machines,  or  other  parts  of  plant,  which  may 
be  conveniently  grouped  together  for  accounting  pur- 
poses. 

Composite  depreciation  is  the  effect  of  physical  or 
functional  depreciation,  or  of  both,  upon  the  whole  plant. 

To  illustrate:  Composing  a  railroad  are  ties,  rails, 
freight  cars,  locomotives,  etc.,  in  various  degrees  of 
depreciation.  •  Some  ties  are  new,  others  are  50  per  cent 
depreciated,  and  still  others  are  nearly  worthless  and 
soon  to  be  replaced  with  new  ones.  All  ties  of  a  given 
age  may  conveniently  be  considered  as  a  unit.  If  this  is 
done,  then  the  unit  depreciation  of  one  group  may  be 
found  to  be  10  per  cent  of  cost  new,  of  another  40  per 
cent  of  cost  new,  and  so  on.  Other  parts  might  be 
similarly  classified.  When,  however,  the  plant  as  an 
entity  is  considered,  it  is  quite  evident  that  if  it  is  kept  in 
a  condition  of  high  efficiency,  it  cannot  be  permitted  to 
depreciate  to  zero  or  any  figure  approaching  zero.  In 
fact,  the  effect  of  repairs  and  replacements  will  be  to 


DEPRECIATION  IN  THEORY  AND  PRACTICE        5 

retain  the  plant  at  perhaps  70  or  80  per  cent  of  its 
original  cost,  and  the  20  or  30  per  cent  depreciation  of 
the  whole  plant  is  what  we  have  called  composite 
depreciation. 

Evidently,  unit  depreciation  and  composite  deprecia- 
tion may  be  either  physical  or  functional  in  character. 
Composite  depreciation  may  be  the  result  of  both. 

The  purpose  of  this  twofold  classification  into  physical 
depreciation  and  functional  depreciation  on  the  one  hand 
and  unit  depreciation  and  composite  depreciation  on  the 
other  hand  will  appear  later. 

MoDEKN  Organization 

During  recent  years  we  have  witnessed  an  increasingly 
great  amount  of  capital  invested  in  fixed  assets,  and  these 
assets  are  usually  owned  by  corporations  which  in  turn 
are  controlled  by  boards  of  directors  and  other  officials. 
The  stockholders  of  the  corporation — who  are  the  real 
owners — oftentimes  have  very  slight  influence  in  the 
determination  of  its  policies  and  procedures.  Conse- 
quently, it  is  of  the  utmost  concern  that  their  investments 
be  protected  and  preserved  by  a  correct  and  duly  con- 
servative policy  on  the  part  of  the  directors  and  other 
corporate  officials. 

Stocks  and  Bonds 

Moreover,  most  corporations  issue  bonds  which  are 
sold  to  the  public  through  associations  of  underwriters. 
These  bonds  are  usually  made  a  first  lien  upon  the  assets 
of  the  corporation.  As  a  protection  to  the  purchasers  of 
bonds,  who  have  no  voice  whatever  in  the  affairs  of  the 
company,  the  physical  constituents  of  the  plant  must  be 
adequately  protected  and  preserved. 

The  income  from  bonds  is  interest;  that  from  stock  is 
dividends.    It  is  a  long-established  principle  of  account- 


6  EARL  A.  SALIERS 

ing  that  before  dividends  may  be  declared  out  of  the 
earnings  of  a  company  all  expenses  must  be  provided 
for.  This  is  merely  another  way  of  saying  that  we  must 
make  sure  that  the  balance  of  the  income  account  which 
is  labeled  net  profits  and  is  to  be  used  for  payment  of 
dividends  or  for  increasing  the  surplus  account,  is  in 
reality  net  profits. 

Depkeciation,  an  Expense 

Depreciation  is  one  of  the  expenses  which  must  be 
deducted  from  gross  profits  before  net  profits  are  deter- 
mined. Some  recent  works  on  accounting  fail  to  follow 
this  very  important  and  fundamental  principle ;  and  it  is 
really  surprising  how  many  corporations  make  the  deduc- 
tion for  accrued  depreciation  from  so-called  net  profits. 

Public  Service  Commissions 

The  whole  matter  has  been  given  an  added  significance 
as  a  consequence  of  the  establishment  by  the  federal  and 
state  governments  of  the  public  service  commissions. 
These  commissions  have  in  many  instances  undertaken 
to  regulate  the  charges  for  services  performed  by  street 
railway,  steam  railway,  gas,  electric,  and  similar  corpora- 
tions, collectively  known  as  public  service  corporations, 
because  of  the  very  intimate  relation  they  bear  to  the 
welfare  of  the  public  in  its  dependence  upon  them  for 
their  services. 

These  commissions  allow  the  public  service  corpora- 
tions to  make  their  expenses,  and  over  and  above  their 
expenses  an  amount  sufficient  to  make  a  fair  return  on 
the  money  invested  in  the  utility  by  the  stockholders. 

Since  depreciation  is  an  expense,  it  is  vastly  important 
that  its  amount  be  carefully  determined  and  accounted 
for;  otherwise  injustice  may  be  suffered  by  those  who 


DEPRECIATION  IN  THEORY  AND  PRACTICE        7 

have  invested   their  money  in   these  very  useful  and 
essential  enterprises. 

Plant  Values 

This  situation  renders  it  necessary  for  the  accountant 
to  maintain  a  very  thorough  and  systematic  record  of 
the  elements  constituting  plant  value.  Some  of  these 
costs  of  plants  are  direct  costs  and  so  may  be  charged 
directly  to  the  proper  account  in  the  Plant  Ledger.  But 
others  are  indirect  costs,  and  since  it  is  impossible  to 
charge  them  directly  to  specific  accounts,  they  are  best 
kept  in  a  special  classification  of  accounts  known  as  the 
Indirect  Cost  Accounts.  The  leading  indirect  costs  enter- 
ing into  an  industrial  plant  are  engineering,  preliminary 
expenses,  insurance  during  construction,  interest  during 
construction,  and  developmental  costs. 

An  examination  of  the  uniform  accounts  prescribed  by 
the  Interstate  Commerce  Commission  mil  disclose  the 
method  pursued  by  that  body  in  prescribing  accounts  for 
the  proper  recording  of  indirect  costs. 

The  Plant  Ledger 

The  Plant  Ledger  should  be  so  arranged  as  to  present 
in  a  sufficiently  concise  form  all  the  facts  necessary  to 
give  a  complete  history  of  the  various  units  composing 
the  pl^t.  It  should  be  a  loose-leaf  book  so  ruled  that  it 
will  contain  space  for  the  proper  distribution  of  the 
depreciation  burden  over  the  life  of  the  plant.  A  speci- 
men page  is  shown  on  page  8. 

The  Plant  Ledger  should  be  controlled  by  a  Plant 
Account  in  the  General  Ledger.  This  control  should  be 
planned  after  the  usual  method,  such  as  is  followed  for 
Accounts  Receivable  and  Accounts  Payable  Controlling 
Accounts. 

(Note :  ^Vlien  the  Plant  Account  in  the  General  Ledger 
shows  cost  less  depreciation,  the  agreement  between  it 


8  *    EARL  A.  SALIERS 

and  the  Plant  Ledger  is  exact,  but  when  a  Depreciation 
Eeserve  Account  is  kept,  the  Plant  Ledger  is  in  agree- 
ment with  the  difference  between  the  Plant  Account  and 
the  Eeserve  for  Depreciation.) 

The  Depreciation  Reserve 

In  addition  to  the  Plant  Account  in  the  General  Ledger, 
an  account  is  kept  in  the  General  Ledger  for  the  purpose 
of  indicating  the  accrued  or  accumulated  depreciation. 
This  account  is  usually  known  as  the  Reserve  for 
Depreciation,  and  its  proper  manipulation  in  the  balance 
sheet  is  a  long  step  toward  the  correct  presentation  of 
accounting  facts. 

Use  of  Depreciation  Reserve 

The  use  of  the  Reserve  for  Depreciation  may  be 
indicated  as  follows : 

The  Plant  Ledger  will  show  the  amount  to  be  deducted 
for  depreciation  from  the  various  units  of  the  plant,  this 
having  first  been  determined  by  one  of  the  several 
methods  in  vognie — straight  line,  reducing  balance,  sink- 
ing fund,  etc.^  (See  short  discussion  of  each  method  in 
the  appendix  at  the  end  of  this  lecture.) 

These,  when  added  together,  will  constitute  the  total 
depreciation  charge,  which  should  be  brought  into  the 
books  by  a  journal  entry,  as  follows : 

Profit  and  Loss     

To  Reserve  for  Depreciation     

To  bring  into  the  books  as  an  expense 
the  depreciation  of  plant  for  the  year  ending 


^  It  has  not  been  thought  desirable  to  introduce  into  this  lecture  a 
lengthy  discussion  of  the  various  formulas  employed  in  deducing  the  depre- 
ciation charge,  because  of  the  large  amount  of  space  that  would  be  required. 
They  may  be  found  fully  illustrated  and  described  in  the  author's  book. 
Principles  of  Depreciation,  obtainable  at  many  libraries. 


DEPRECIATION  IN  THEORY  AND  PRACTICE 


k 


^ 


vS 


SO 

ta.U 


g 


I 


10  EARL  A.  SALIERS 

To  illustrate,  let  the  following  balance  sheet  represent 
the  status  of  a  newly  established  business : 

BALANCE  SHEET  OF  COMPANY  X,  AS  AT 

Building  and  machinery     10,000  Capital  Stock     12,000 

Cash  2,000 


12,000  12,000 


Next,  let  us  assume  that  during  the  first  year  the  depre- 
ciation of  ^^  building  and  machinerj^"  amounts  to  5  per 
cent  of  the  cost,  or  .05  X  $10,000  =  $500.  In  addition  to 
the  usual  closing  entries  made  at  the  end  of  the  year,  or 
other  accounting  period,  the  following  entry  will  intro- 
duce into  the  books  the  adjustment  necessary  to  record 
the  effect  of  the  depreciation: 

Profit  and  Loss  ^  $500 

To  Reserve  for  Depreciation  $500 

The  Eeserve  for  Depreciation  should  now  appear  in 
the  balance  sheet,  either  on  the  liability  side,  as  follows : 

BALANCE  SHEET   OF   COMPANY  X,   AS  AT 


Building  and  machinery  10,000     Capital  Stock  12,000 

Cash  2,500     Reserve  for  Depreciation       500 


12,500  12,500 

or,  as  is  coming  to  be  regarded  as  the  better  form : 


BALANCE  SHEET  OF   COMPANY  X,   AS   AT 


Building  and  Machinery       10,000  Capital  Stock  12,000 

Less :  Reserve  for  Depreciation  500     9,500 


Cash  2,500 


12,000  12,000 

Development  of  the  Reserve 

Next,  we  shall  study  the  uses  and  development  of  the 
depreciation  reserve.    It  must  be  kept  in  mind  that  the 


DEPRECIATION  IN  THEORY  AND  PRACTICE      11 

object  of  bringing  the  depreciation  charge  into  the  books 
at  the  close  of  each  accounting  period  is  to  have  the  Profit 
and  Loss  Account  charged  with  the  actual  loss  occurring 
as  the  result  of  depreciation.  This  is  done  whether  the 
loss  thus  occurring  is  actually  compensated  for  by 
replacements  during  the  period  or  not.  In  fact,  the  value 
of  the  reserve  arises  chiefly  from  the  fact  that  deprecia- 
tion is  not  usually  made  good  during  the  accounting 
period;  but  oftentimes  many  years  intervene  between 
depreciation  and  replacement.  The  depreciation  reserve 
here  enters  to  indicate  the  extent  to  which  depreciation 
has  exceeded  replacements. 

In  practice  this  works  out  as  follows.  During  the 
earlier  years  of  the  plant's  existence,  although  few 
replacements  are  required,  depreciation  goes  on  apace 
and  must  be  charged  to  the  Profit  and  Loss  Account  and 
credited  to  the  depreciation  reserve.  In  this  way,  the 
depreciation  reserve  continues  to  increase  in  amount, 
and  would  continue  to  increase  indefinitely  were  it  not 
for  the  fact  that  another  class  of  journal  entries  soon 
begins  to  reduce  the  amount  of  the  reserve,  and  in  an 
increasing  degree,  until  finally,  when  the  plant  has  arrived 
at  its  normal  condition,  and  replacements  are  equal  to 
the  charges  for  depreciation,  the  reserve  remains  about 
stationary,  like  a  reservoir^  from  which  water  is  pumped 
as  rapidly  as  it  is  accumulated  from  the  inlets. 

Replacements 

When  any  part  of  the  plant  is  replaced  an  adjustment 
must  be  made  crediting  Plant  Account  and  charging 
Reserve  for  Depreciation.  In  the  Plant  Ledger  the  indi- 
vidual unit  account  must  at  the  same  time  be  credited: 

Reserve  for  Depreciation  20,000 

To  Freight  Cars  20,000 

To  adjust  books  when  freight  ears 
costing  $20,000  are  scrapped. 


12  EARL  A.  SALIERS 

By  this  entry  the  Freight  Cars  Account  is  credited  with 
the  cost  price,  the  same  amount  with  which  it  was  charged 
when  the  cars  were  purchased,  perhaps  twenty  years 
before. 

The  Depeeciation  Fund 

Considerable  confusion  and  misunderstanding  has 
existed  in  the  matter  of  the  relationship  of  depreciation 
reserves  and  depreciation  funds.  We  have  already  indi- 
cated the  correct  use  of  the  depreciation  reserve.  We 
shall  now  consider  the  use  of  the  depreciation  fund. 

Depreciation  reserve  accounts  are  essentially  adjust- 
ment accounts  and  their  proper  position  in  the  balance 
sheet  is  on  the  liability  side,  or  they  may  be  shown 
as  a  deduction  from  the  asset  accounts  to  which  they 
refer — the  latter  place  being  the  better  one,  as  we  have 
noted. 

Depreciation  fund  accounts,  on  the  other  hand,  are 
asset  accounts,  and  should  be  so  indicated  in  the  balance 
sheet.  Depreciation  reserves  may  be,  and  usually  are, 
established  without  the  formation  of  corresponding  de- 
preciation funds.  The  object  of  the  depreciation  reserve 
is  to  charge  the  Profit  and  Loss  Account  with  the  proper 
amount  of  expense  resulting  from  plant  deterioration 
and  thus  prevent  an  overstatement  of  net  profits  and 
consequent  excessive  disbursements  in  the  form  of  divi- 
dends. Such  a  procedure  means  that  somewhere  among 
the  assets  there  exists  this  reserved  value  which  other- 
wise might  have  been  wiped  out  as  the  result  of  an 
exaggeration  of  the  net  profits  and  consequent  overpay- 
ment of  dividends. 

Should  the  management  determine  to  locate  more  defi- 
nitely this  amount  of  wealth  or  value  retained  among 
the  assets  as  a  result  of  the  establishment  of  the  depre- 
ciation reserve,  it  may  do  so  by  designating  a  part  of 
the  assets,  of  proper  amount,  as  a  depreciation  fund. 


DEPRECIATION  IN  THEORY  AND  PRACTICE      13 

Since  cash  is  the  most  liquid  of  all  assets  and  the  most 
easily  transferred,  cash  is  quite  naturally  the  asset  from 
which  the  fund  will  be  created.  For  example,  take  the 
case  of  Company  X,  having  a  balance  sheet  as  indicated 
on  page  11.  If  the  management  determines  to  establish 
a  depreciation  fund  equal  in  amount  to  the  reserve  for 
depreciation,  viz.,  $500,  the  following  cash  book  entry 
is  necessary: 

Depreciation  Fund  $500 

To  Cash  ,  $500 

To  establish  a  depreciation  fund  to 
meet  cost  of  future  replacements. 

The  balance  sheet  then  appears  as  below: 

BALANCE  SHEET  OP  COMPANY  X,  AS  AT 

Buildings  and  Machinery        10,000  Capital  Stock  12,000 

Less :  Reserve  for  Depreciation    500  9,500 

Depreciation  Fund  500 

Cash  2,000 


12,000  12,000 

Value  of  the  Fund 

It  should  be  remembered  that  the  establishment  of  a 
depreciation  fund  is  a  matter  to  be  determined  entirely 
by  the  policy  of  the  management.  If  the  fund  is  estab- 
lished, it  will  probably  be  placed  aside  in  the  form  of 
investments  of  one  kind. or  another.  Hence  interest  will 
accumulate  thereon,  and  if  this  is  in  turn  added  to  the 
fund,  it  will  grow  more  rapidly  than  if  it  is  turned  back 
into  the  general  income  of  the  business.  It  follows  that 
if  the  interest  is  added  to  the  principal  of  the  fund  the 
annual  instalments  into  the  fund  should  not  be  as  large 
as  when  the  interest  is  not  so  added. 

The  value  to  the  establishment  of  such  funds  would, 
in  some  eases  at  least,  appear  to  be  problematical,  if  not 


14  EARL  A.  SALIERS 

positively  undesirable.  If  a  company  is  prosperous,  can 
it  not  employ  the  cash  to  better  advantage  by  permitting 
it  to  perform  the  usual  function  of  a  current  asset? 
The  really  important  step  is  the  formation  of  the  depre- 
ciation reserve,  and  failure  to  do  so  is  a  serious  error. 
The  establishment  of  the  depreciation  fund  is  rather  a 
matter  of  policy,  and  the  failure  to  do  so  may  be  advan- 
tageous rather  than  otherwise.  Depreciation  funds  are 
used  in  practice,  however,  and  there  is  good  authority 
for  their  use  under  proper  conditions. 

Application  of  Principles 

We  shall  now  state  and  discuss  some  of  the  problems 
in  which  the  depreciation  question  plays  an  important 
part.  These  problems  have  arisen  mainly  as  the  result 
of  the  peculiar  relationship  which  has  grown  up  between 
our  government  on  the  one  hand  and  industry  and  com- 
merce on  the  other.  We  shall  give  this  subject  a  three- 
fold classification,  treating  it  in  the  following  order: 

1.  The  Income  Tax. 

2.  Valuation. 

3.  Uniform  Systems  of  Accounts. 

1.  THE  INCOME  TAX 

The  income  tax  is  now  recognized  as  a  fixed  part  of 
our  fiscal  system,  and  the  future  is  likely  to  see  an 
extension  rather  than  a  diminution  of  this  tax.  Depre- 
ciation is  an  important  factor  in  a  discussion  of  the 
income  tax  because  net  income,  on  which  the  tax  is  com- 
puted, can  be  determined  only  after  proper  allowance 
has  been  made  for  depreciation;  and  in  this  connection 
some  rather  complicated  questions  have  arisen.  To 
illustrate : 

How  shall  the  depreciation  of  goodwill  be  determined, 
and  what  allowance,  if  any,  shall  be  made  therefor? 


DEPRECIATION  IN  THEORY  AND  PRACTICE      15 

Shall  an  allowance  be  made  for  bad  debts? 

How  shall  patents  be  depreciated? 

What  rules  shall  we  apply  in  the  case  of  coal  lands 
and  other  natural  deposits? 

These  and  many  similar  questions  have  been  answered 
by  the  U.  S.  Treasury  Department  and  published  in 
pamphlet  form  under  the  title,  Incom,e  Tax  Regulations. 
The  most  important  of  these  regulations  may  be  sum- 
marized, as  follows: 

1.  The  net  income  of  a  corporation  is  determined  by 
deducting  from  the  gross  income  (a)  all  expenses  of 
maintenance  and  operation  and  (b)  all  losses  actually 
sustained,  including  a  reasonable  allowance  for  depre- 
ciation. 

2.  In  the  case  of  mines,  a  reasonable  allowance  for 
depletion  of  ores  and  mineral  deposits,  not  to  exceed  5 
per  cent  of  the  gross  value,  at  the  mine,  of  the  output 
for  the  year  under  consideration. 

3.  If  property  has  been  acquired  after  January  1, 
1909,  and  is  disposed  of,  the  difference  between  cost  and 
selling  price  must  be  added  to,  or  subtracted  from,  the 
gross  income  of  the  year  in  which  it  is  sold,  accordingly 
as  it  represents  gain  or  loss. 

.    4.    No  allowance  is  granted  for  depreciation  of  good- 
will. 

5.  A  proper  allowance  may  be  made  for  bad  debts, 
but  to  be  effective  it  must  be  actually  charged  off  on  the 
books. 

6.  Patents  are  monopolies  granted  for  a  period  of 
seventeen  years ;  hence,  one-seventeenth  may  be  charged 
off  their  actual  cash  cost.  If  a  patent  becomes  worth- 
less before  the  expiration  of  the  seventeen-year  period, 
whatever  portion  of  the  cost  has  not  been  written  off 
may  be  written  off  in  the  year  that  such  worthlessness 
is  discovered. 


16  EARL  A.  SALIERS 

7.  In  case  of  bonds  purchased  above  par,  the  pre- 
mium may  be  written  off  each  year  so  that  book  value 
and  redemption  value  will  be  equal  when  the  bonds  fall 
due.  The  amortization  should  be  proportioned  with 
respect  to  (a)  purchase  price,  (b)  maturity  value,  and 
(c)  time  of  maturity. 

In  case  of  bonds  issued  below  par,  to  be  redeemed 
at  par  at  date  of  maturity,  the  resulting  loss  should  be 
similarly  prorated. 

8.  Such  an  allowance  may  be  made  for  depreciation 
of  timber  lands  as  will  return  the  amount  actually 
invested  in  them. 

9.  Depreciation  of  mines  must  likewise  be  based  on 
the  actual  cbst  of  the  deposits. 

2.  VALUATIONS 

Another  important  problem,  the  solution  of  which 
necessitates  a  consideration  of  the  depreciation  question, 
is  that  of  the  valuation  of  the  properties  of  public 
utility  companies.  This  problem  has  arisen  in  the  fol- 
lowing manner. 

Our  so-called  public  utility  corpoj'ations  operate  on  an 
essentially  different  basis  than  most  of  the  private  cor- 
porations. Public  utility  companies  rarely  exist  on  a 
basis  of  competition  with  one  another,  but  in  nearly 
every  instance  they  possess  certain  monopoly  privileges 
which  have  been  granted  to  them  by  national,  state,  or 
municipal  government.  Thus,  street  car  companies 
receive  franchises  from  the  municipality  they  serve  and 
are  granted  the  exclusive  right  of  constructing  car  lines 
in  the  streets.  Water,  gas,  and  electric  light  companies 
receive  similar  franchises.  Evidently,  to  permit  two  or 
more  companies  to  enter  into  competition  for  the  supply 
of  street-car  service,  or  gas,  water,  or  electric  current^ 
would  under  ordinary  circumstances  result  in  a  very 
costly  and  wasteful  duplication  of  equipment.    The  same 


DEPRECIATION  IN  THEORY  AND  PRACTICE      17 

is  true  of  railroads;  and  the  past  history  of  American 
railroads  has  shown  that  they  cannot  successfully 
operate  on  a  basis  of  open  competition. 

When  competition  does  exist  without  causing  such 
waste  of  duplication,  it  serves  as  an  incentive  on  the 
part  of  company  officials  to  keep  the  prices  of  their 
commodities  at  a  reasonably  low  figure,  lest  they  be 
undersold  by  their  competitors.  The  retail  grocery  busi- 
ness serves  as  a  very  good  illustration  of  this.  But 
where  competition  does  not  serve  as  an  adequate  rate 
regulator,  as  in  the  case  of  most  public  utility  com- 
panies, the  question  arises,  what  authority  shall  fix  rates 
or  prices  and  how  shall  this  authority  determine  what 
rates  or  prices  are  just  and  equitable  to  both  the  public 
and  the  company? 

This  duty  of  fixing  rates  has  been  delegated  to  the 
public  service  commissions,  and  the  basis  upon  which 
they  proceed  will  be  the  subject  of  our  further  inquiry. 

Capital  legitimately  invested  ought  to  return  to  the 
investor  a  reasonable  income.  What  constitutes  a  rea- 
sonable income  on  capital  may  differ  somewhat  with  the 
circumstances — money  market,  risk  involved,  etc.  For 
purposes  of  this  discussion  let  us  assume  that  6  per  cent 
constitutes  a  reasonable  income  on  an  investment  in  a 
public  utility. 

To  the  commission  which  seeks  to  perxait  a  utility  to 
earn  a  net  income  of  6  per  cent  on  the  investment  cer- 
tain problems  will  present  themselves,  as  follows : 

1.  What  is  the  actual  cash  value  of  the  investment  in 
the  utility  under  consideration? 

2.  In  determining  the  various  expenses  that  the 
utility  company  may  be  permitted  to  deduct  in  order 
to  arrive  at  the  net  profits,  what  allowance  ought  to  be 
made  for  current  depreciation  losses? 

3.  Given  the  original  cash  cost  of  the  utility  in  ques- 
tion, shall  the  retu^  of  6  per  cent  be  granted  on  thi§ 


18  EARL  A.  SALIERS 

original  cost,  or  on  the  present  depreciated  value  of  the 
plant;  and  shall  any  allowance  be  made  for  apprecia- 
tion,  as  of  land,  roadbed,  etc.,  due  to  such  causes  as 
increase  of  population,  natural  community  growth,  etc. 
— increases  in  the  value  of  the  property  not  resulting 
from  additional  investments  of  money? 

Two  well-known  theories  have  arisen  as  a  result  of 
the  attempt  to  solve  these  questions.  One  is  known  as 
the  cost-to -reproduce  theory.  Stated  simply,  it  means 
that  the  public  utility  company  should  be  permitted  to 
earn  a  reasonable  return  on  whatever  sum  it  would 
require  to  reproduce  its  plant  under  present  conditions. 
Clearly  such  a  theory  is  advantageous  to  the  corpora- 
tion ;  consequently,  we  find  it  advocated  by  engineers  and 
other  experts  in  the  employ  of  the  public  service  cor- 
porations. 

Under  normal  conditions  community  growth  is  suffi- 
cient, during  the  period  of  a  few  years,  to  increase  the 
value  of  land  so  greatly  that  cost  of  reproduction  of  a 
plant  may  be  considerably  enhanced.  Consequently,  the 
cost-of-reproduction  basis  for  rates  oftentimes  gives  to 
the  corporation  a  certain  proportion  of  income  over  and 
above  that  which  it  would  realize  were  it  strictly  limited 
to  an  adequate  return  upon  its  original  investment.  The 
cost-of-reproduction  theory  has  been  upheld  in  certain 
of  the  courts  and  by  prominent  writers  on  the  subject. 

The  CO st-of -reproduction-less-depreciation  theory  has 
also  been  upheld  by  many  prominent  authorities.  Briefly, 
it  holds  that  it  is  improper  to  grant  a  reasonable  return 
upon  what  it  would  cost  to  reproduce  a  plant,  since  to 
do  so  would  be  to  make  no  allowance  for  the  depreciated 
condition  of  the  plant,  which  might  conceivably  amount 
to  as  much  as  20  or  30  per  cent  of  the  cost  of  repro- 
duction. This  theory  does  not  go  so  far  as  to  deny  the 
company  the  benefit  of  the  increase  in  the  value  of  its 
lands,  but  it  does  deny  that,  in  addition  to  receiving  a 


DEPRECIATION  IN  THEORY  AND  PRACTICE      19 

reasonable  return  upon  this  increased  value,  the  com- 
pany may  justly  expect  a  return  upon  present  cost  of 
reproduction  new,  when  its  plant  is  actually  in  a  depre- 
ciated condition. 

In  opposition  to  this  contention,  the  advocates  of  the 
cost-to-reproduce  theory  assert  that  as  long  as  a  plant 
is  performing  adequately  its  function  of  providing  serv- 
ice to  the  public  it  is  no  concern  of  the  public  what  the 
amount  and  extent  of  depreciation  may  be;  and  that 
consequently  depreciation  ought  not  to  be  deducted  in 
determining  the  value  of  a  plant  for  rate-making  pur- 
poses. 

The  question  appears  to  hinge  largely  on  the  question 
of  the  adequacy  with  which  depreciation  has  been  cared 
for  in  the  accounts  of  the  company.  If  adequate  reserves 
for  depreciation  covering  all  accrued  depreciation  have 
been  established,  this  means  that  in  the  past  the  cor- 
poration has  been  granted  an  allowance,  through  the 
annual  depreciation  charge,  for  all  depreciation  accrued 
to  date,  and  at  the  same  time,  has  been  granted  a  reason- 
able return  on  its  investment.  This  has  resulted  in  the 
establishment  of  a  depreciation  reserve  and  the  corre- 
sponding retention  of  values  among  the  assets  equiva- 
lent in  amount  to  this  reserve.  If  this  reserve  has  been 
specially  tabulated  and  set  aside  as  a  fund,  its  exist- 
ence will  not  be  questioned.  But  instead  of  being  placed 
aside  as  a  fund  it  might  have  been  employed  for  either 
of  two  purposes,  viz.,  (a)  to  liquidate  bonded  or  other 
indebtedness  of  the  company  or  (b)  to  make  extensions 
to  the  plant. 

If  bonded  or  other  indebtedness  is  liquidated,  then  it 
seems  clear  that  the  investment  has  been  diminished  by 
that  amount,  and  consequently  expenses  in  the  form  of 
interest  charges  have  been  diminished.  Consequently,  a 
smaller  return  would  be  adequate  to  provide  a  suitable 
return  on  the  remaining  investment. 


20  EARL  A.  SALIERS 

On  the  other  hand,  if  the  fund  is  expended  in  the 
making  of  extensions,  the  depreciation  of  the  original 
plant  has  been  made  good  by  the  extensions  paid  for 
out  of  the  depreciation  fund.  In  this  case  the  fund  is 
retained  in  the  business,  and  therefore  the  return  ought 
not  to  be  diminished. 

Thus  it  is  seen  how  important  is  sound  accounting 
procedure  when  viewed  from  the  standpoint  of  finance 
and  governmental  control.  Well-kept  records  ought  to 
be  an  aid,  rather  than  a  hindrance,  in  securing  justice 
and  fair  treatment  at  the  hands  of  the  public  service 
commissions.  Indeed,  good  accounting  systems  are 
becoming  absolutely  essential  to  the  relationship  that 
has  grown  up  between  government  and  industry.  This 
truth  has  been  greatly  emphasized  by  the  work  of  the 
Interstate  Commerce  Commission,  which  has  established 
certain  standard  procedures  in  handling  depreciation  in 
railroad  accounting  which  will  be  the  next  topic  con- 
sidered. 

3.  UNIFORM  SYSTEMS  OF  ACCOUNTS 

Our  consideration  of  this  subject  will  be  limited  to 
the  uniform  accounts  for  railroads  prescribed  by  the 
Interstate  Commerce  Commission  and  to  certain  of  the 
requirements  of  the  New  York  Public  Service  Commis- 
sion for  the  First  District.  These  will  be  sufficient  to 
show  the  present  tendency  of  commission  control  of 
accounting  for  depreciation. 

The  uniform  system  of  accounts  for  railroads,  which 
went  into  effect  on  July  1,  1914,  was  the  result  of  a 
desire  on  the  part  of  the  Interstate  Comrtierce  Commis- 
sion to  obtain  full  information  concerning  railway 
construction  and  management.  The  efforts  of  the  Com- 
mission, seconded  by  railway  accounting  officers,  has 
resulted  in  the  promulgation  of  a  system  of  accounts 


DEPRECIATION  IN  THEORY  AND  PRACTICE      21 

which,  although  not  perfect,  fulfils  some  important 
requirements. 

The  expenses  of  running  a  railroad  may  be  classified 
as  follows:  (a)  maintenance  of  way  and  structures,  (b) 
maintenance  of  equipment,  (c)  transportation  expenses, 
and  (d)  general  expenses.  We  are  here  concerned  with 
(a)  and  (b). 

An  examination  of  the  Interstate  Commerce  Commis- 
sion classification  of  accounts  for  maintenance  of  way 
and  structures  indicates  no  less  than  seventy-nine 
accounts  among  which  these  expenses  are  distributed.  Of 
these  the  following  cover  depreciation,  and  at  the  same 
time  afford  for  the  student  a  study  of  the  proper  analysis 
of  the  elements  that  enter  into  the  way  and  structures  of  a 
railroad.2 

Roadway — Depreciation 

Underground  Power  Tubes — ^Depreciation 

Tunnels  and  Subways — Depreciation 

Bridges,  Trestles,  and  Culverts — Depreciation 

Elevated  Structures — Depreciation 

Ties — Depreciation 

Rails — Depreciation 

Other  Track  Material — Depreciation 

Ballast — Depreciation 

Right  of  Way  Fences — Depreciation 

Snow  and  Sand  Fences  and  Snowsheds — Depreciation 

Crossing  and  Signs — Depreciation 

Station  and  Office  Buildings — Depreciation 

Roadway  Buildings — Depreciation 

Water  Stations — Depreciation 

Fuel  Stations — Depreciation. 

Shop  and  Engine  Houses — Depreciation 

Grain  Elevators — Depreciation 

Storage  Warehouses — Depreciation 

Wharves  and  Docks — Depreciation 

Coal  and  Ore  Wharves — Depreciation 

Gas  Producing  Plants — Depreciation 

Telegraph  and  Telephone  Lines — Depreciation 

Signals  and  Interloekers — Depreciation 


-  These  accounts  shall  include  charges  covering  the  current  losses  from 
depreciation. 


22  EARL  A.  SALIERS 

Power  Plant  Dams,  Canals,  and  Pipe  Lines — Depreciation 

Power  Plant  Buildings — Depreciation 

Power  Substation  Buildings — Depreciation 

Power  Transmission  Systems — Depreciation 

Power  Distribution  Systems — Depreciation 

Power  Line  Poles  and  Fixtures — Depreciation 

Underground  Conduits — Depreciation 

Miscellaneous  Structures — Depreciation 

Paving — Depreciation 

Roadway  Machines — Depreciation 

Thus  for  each  subdivision  of  way  and  structures  a 
depreciation  account  is  prescribed.  This  plan  became 
obligatory  on  July  1,  1914. 

For  railroad  equipment,  however,  the  depreciation 
charge  remains  optional. 

These  accounts  must  be  carefully  distinguished  from 
the  depreciation  reserve  accounts.  The  accounts  classi- 
fied above  are  expense  accounts  and  are  closed  into 
Profit  and  Loss,  while  the  corresponding  credits  form 
the  reserve  accounts,  which  enter  the  balance  sheet.  The 
Commission  prescribes  three  reserve  accounts  for  depre- 
ciation, as  follows: 

Accrued  Depreciation — Road. — This  account  shall  be 
credited  with  amounts  charged  to  Operating  Expenses 
or  other  accounts  to  cover  the  depreciation  of  fixed 
improvements,  the  cost  of  which  is  included  in  account 
No.  701,  Investment  in  Road  and  Equipment,  or  in 
account  No.  702,  Improvements  on  Leased  Railway 
Property. 

When  any  fixed  property  is  destroyed,  sold,  or  other- 
wise retired  from  service,  the  amount  included  in  this 
account  with  respect  to  the  property  retired  sliall  be 
charged  hereto. 

Accrued  Depreciation  —  Equipment.  -^  This  account 
shall  be  credited  with  amounts  charged  to  Operating 
Expenses  or  other  accounts  to  cover  the  depreciation 
of  the  accounting  company's  equipment. 


DEPRECIATION  IN  THEORY  AND  PRACTICE      23 

When  any  equipment  is  destroyed,  sold,  or  otherwise 
retired  from  service,  the  amount  included  within  this 
account  with  respect  to  the  property  retired  shall  be 
charged  hereto. 

Accrued  Depreciation — Miscellaneous  Physical  Prop- 
erty.— This  account  shall  be  credited  with  amounts 
charged  to  Income  or  other  accounts  to  cover  the  depre- 
ciation of  property  the  cost  of  which  is  included  in 
account  No.  705,  Miscellaneous  Physical  Property. 

When  any  miscellaneous  physical  property  is  de- 
stroyed, sold,  or  otherwise  retired  from  service,  the 
amount  included  in  this  account  with  respect  to  the 
property  retired  sh^ll  be  charged  hereto. 

The  reader  will  notice  that  great  care  is  taken  in 
accounting  for  depreciation  of  railroad  property,  and 
this  in  spite  of  the  fact  that  railroad  companies  usually 
have  such  extensive  properties  that  current  repairs  and 
replacements  do,  in  a  very  large  measure,  remain  uni- 
form from  year  to  year.  When  a  firm's  capital  is 
invested  in  a  few  buildings,  it  is  much  less  likely  that 
current  repairs  and  replacements  will  be  uniform,  and 
consequently  it  is  more  important  that  accruing  depre- 
ciation be  adequately  charged  to  Profit  and  Loss  and 
credited  to  the  proper  reserve  account. 

The  requirements  of  the  New  York  Public  Service 
Commission  for  the  First  District  are,  in  principle,  the 
same  as  those  of  the  Interstate  Commerce  Commission. 
Thus,  in  its  Uniform  System  of  Accounts  for  Electrical 
Corporations,  provision  is  made  for  a  depreciation 
reserve  under  the  following  title : 

ACCRUED  AMORTIZATION  OF  CAPITAL 

Credit  to  this  account  such  amounts  as  are  charged  from  time 
to  time  to  Operating  Expenses  or  other  accounts  to  cover  depre- 
ciation of  plant  and  equipment,  and  other  amortization  of  capital. 
When  any  capital  is  retired  from  service,  the  original  money  cost 
thereof  (estimated  if  not  known,  and  where  estimated,  that  fact 


24  EARL  A.  SALIERS 

and  the  facts  upon  which  the  estimate  is  based  shall  be  stated  in 
the  entry),  less  salvage,  shall  (except  as  provided  in  account  No. 
ElOO,  ''Fixed  Capital,  December  31,  1908,")  be  charged  to  this 
account.  The  amount  originally  entered  or  contained  in  the 
charges  to  any  capital  account  in  respect  of  such  capital  so  going 
out  of  service  shall  be  credited  to  such  capital  account,  and  any 
necessary  adjusting  entry  made  to  the  appropriate  sub-account 
under  the  account  Corporate  Surplus  or  Deficit. 

In  studying  the  above  and  other  illustrations  of  the 
practical  application  of  the  depreciation  reserve,  the 
student  should  be  careful  not  to  be  misled  by  the  variety 
of  terms  which  mean  essentially  the  same  thin^.  It 
makes  little  difference  whether  we  call  the  reserve  for 
depreciation,  ** Accrued  Amortization  of  Capital,''  or 
** Accrued  Depreciation,"  or  employ  some  other  expres- 
sion. The  essential  thing  to  remember  is  that  the 
reserve  for  depreciation  is  an  adjustment  account 
employed  for  the  purpose  of  securing  greater  accuracy 
and  a  better  presentation  of  facts  in  the  complex  field 
of  modern  industrial  and  commercial  enterprises. 


APPENDIX 

The  Straight-Line  Method 

When  this  plan  is  pursued  an  equal  amount  is  charged  off  to 
depreciation  each  year,  and  a  corresponding  credit  is  made  to 
the  reserve  for  depreciation.  It  is  the  simplest  of  all  methods, 
and  in  using  it  no  complicated  computations  are  required. 

If  V   represents  the  original  investment, 
n  the  lifetime  in  years, 
y  the  salvage  value,  and 
X  the  equal  annual  charge,  then 


which  is  the  general  form  of  the  straight-line  formula,  applicable 
to  any  amount  and  any  length  of  time. 

The  Reducing-Balance  Method 

This  method  necessitates  heavy  charges  during  the  early  years 
of  the  plant's  lifetime,  since  each  year  an  equal  percentage  is 
taken  on  the  reduced  value  as  given  at  the  close  of  the  preceding 
year.  The  shorter  the  lifetime  of  the  plant  the  larger  must  be 
this  percentage  in  order  that  the  values  may  be  reduced  to  salvage 
value  or  zero  in  the  given  time.  For  example,  if  the  life  of  a 
given  asset  is  twenty-five  years,  its  original  cost  100  dollars,  and 
its  salvage  value  1  dollar,  then  each  year  the  balance  from  the 
preceding  year  must  be  reduced  by  16.82  per  cent  of  its  amount. 

If  y  represents  salvage  value, 
V   the  original  value, 
n  the  lifetime  in  years,  and 
X   the  percentage  required,  then 


=^-Tv 


which  is  the  general  form   of  the  reducing-baJanee  formula 
applicable  to  any  amount  and  to  any  length  of  time. 

25 


26  EARL  A.  SALIERS 

The  Sinking-Fund  Method 

According  to  this  plan  a  definite  fixed  amount  of  money  is 
placed  aside  periodically  to  accumulate  at  compound  interest. 
It  is  assumed  that  the  amounts  thus  reserved  plus  their  accumu- 
lations of  interest  will  at  the  end  of  a  given  time  be  sufficient  to 
make  the  desired  replacement. 

If  V  equals  original  value,  or  fund  to  be  accumulated, 
n  the  period  of  years,, 
r   the  rate  of  interest, "and 
X  the  amount  to  be  set  aside  annually,  then 

ir-l) 
x  =  V 


(r^  — 1) 


which  is  the  general  form  of  the  sinking  fund  formula  and 
applicable  to  any  amount,  for  any  length  of  time,  at  any  rate  of 
interest. 

The  Annuity  Method 

By  this  plan,  the  annual  depreciation  charge  is  determined  by 
finding  a  sum  which  when  deducted  each  year  from  the  invest- 
ment remaining  from  the  previous  year  and  increased  by  the 
interest  on  the  investment  at  a  given  rate,  will  reduce  the  invest- 
ment to  salvage  or  zero  in  the  given  time,  and  at  the  same  time 
return  the  full  amount  of  the  interest  on  the  investment  as  it 
stands  at  the  end  of  each  year.  Interest,  which  is  included  in  the 
depreciation  return,  it  must  be  remembered,  is  on  the  remaining 
investment. 

If  V   represents  the  original  value, 
y  the  salvage  value, 
n   the  lifetime  of  the  asset, 
r    the  rate  of  interest  plus  1,  and 
X  the  equal  annual  charge,  then 

-/^"^-  (r-1) 


(rw  —  1) 


which  is  the  general  form  of  the  annuity  formula,  applicable  to 
any  amount,  for  any  length  of  time,  and  apy  rate  of  interest. 


TEST  QUESTIONS 

These  questions  are  for  the  reader  to  use  in  testing 
his  knowledge  of  the  lecture.  The  answers  should  be 
written  out  fully  in  a  notebook,  but  are  not  to  be  sent  in. 

1.  Why  is  the  depreciation  problem  one  of  live  importance? 

2.  Define:    depreciation,    physical   depreciation,    functional 
depreciation. 

3.  Defijie:  obsolescence,  inadequacy. 

4.  What  is  unit  depreciation,  composite  depreciation? 

5.  Why  is  depreciation  an  expense? 

6.  How  is  the  depreciation  problem  related  tOv  commission 
regulation  ? 

7.  Describe  the  use  of  the  Plant  Ledger. 

8.  What  is  the  value  of  the  depreciation  reserve  ? 

9.  Show   how   the   growth   of   the    depreciation   reserve   is 
limited. 

10.  What  entry  is  made  when  a  unit  of  the  plant  is  replaced  ? 

11.  Describe  the  depreciation  fund. 

12.  Why  must  depreciation  be  considered  in  determining  the 
income  tax? 

13.  What  allowance  does  the  government  make  for  exhaus- 
tion of  mineral  deposits  in  calculating  the  income  tax  ? 

14.  What  is  essential  to  make  bad  debts  a  proper  allowance 
in  the  income  tax? 

15.  How  does  depreciation  enter  into  the  valuation  question  ? 

16.  Why  are  public  utilities  usually  monopolies? 

17.  What  are  the  cost-of -reproduction  and  the  cost-of -repro- 
duction-less-depreciation theories  ? 

18.  How  does  the  Interstate  Commerce  Commission  subdivide 
railwa}^  property  for  purposes  of  determining  depreciation  ? 

19.  How  does  it  establish  a  depreciation  reserve? 

20.  How  does  the  New  York  Public  Service  Commission  for 
the  First  District  care  for  depreciation? 

27 


14  DAY  USE 

RBTURN  TO  DESK  FROM  WHICH  BORROWED 

LOAN  DEPT. 

«_       ,  Tel.  No.  642-3405  ^ 

P^^f?  f  ^'i  ^  'nade  4  days  prior  to  date  due. 
Renewed  books  are  subject  to  immediate  recaU. 


RLQ'ttm  ifc»>^  '72-1  wo  8 


m. 


01 


iMi 


;v;Ai 


/I/ 


^  LD21A-40m-3,'72 
(Qll73810)476-A-32 


.General  Library 

University  of  California 

Berkeley 


GAYLAMOUNT 

PAMPHLET  BINDER 

Manu/aetured  by 

GAYLORD  BROS.  In«. 

Syracus*,  N.  Y. 

StocVton,  Calif. 


402177 


UNOVERSITV  OF  CALIFORNIA  UBRARY 


